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"Taylored rules". Does one fit (or hide) all?

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Abstract

Modern monetary policymakers consider a huge amount of information to evaluate events and contingencies. Yet most research on monetary policy relies on simple instrument rules and one relevant underpinning for this choice is the good empirical fit of the Taylor rule. This paper challenges the solidness of this foundation. We investigate the way the coefficients of the Taylor-type rules change over time according to the evolution of general economic conditions. We model the Federal Reserve reaction function during the Greenspan’s tenure as a Logistic Smoothing Transition Regime model in which a series of economic meaningful transition variables drive the transition across monetary regimes. We argue that estimated linear rules are weighted averages of the actual rules working in the diverse monetary regimes, where the weights merely reflect the length and not necessarily the relevance of the regimes. Accordingly, an estimated linear Taylor-type reaction function tends to resemble the rule adopted in the longest regime. Thus, the actual presence of finer monetary policy regimes corrupts the general predictive and descriptive power of linear Taylor-type rules. These latter, by hiding the specific rules at work in the various finer regimes, lose utility directly with the uncertainty in the economy.

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File URL: http://repec.graduateinstitute.ch/pdfs/Working_papers/HEIWP04-2005.pdf
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Bibliographic Info

Paper provided by Economics Section, The Graduate Institute of International Studies in its series IHEID Working Papers with number 04-2005.

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Length: 69 pages
Date of creation: 01 Sep 2005
Date of revision: Apr 2006
Handle: RePEc:gii:giihei:heiwp04-2005

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Keywords: Instrument Rules; LSTR; Monetary Policy Regime; Risk Management; Taylor Rule;

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References

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  1. Castelnuovo, Efrem, 2003. "Taylor rules, omitted variables, and interest rate smoothing in the US," Economics Letters, Elsevier, vol. 81(1), pages 55-59, October.
  2. Paolo Surico & Antonello D'Agostino & Luca Sala, 2005. "The Fed and the Stock Market," Computing in Economics and Finance 2005 293, Society for Computational Economics.
  3. Svensson, Lars O, 2005. "Monetary Policy with Judgment: Forecast Targeting," MPRA Paper 819, University Library of Munich, Germany.
  4. Christopher Martin & Costas Milas, 2004. "Modelling Monetary Policy: Inflation Targeting in Practice," Economica, London School of Economics and Political Science, vol. 71(281), pages 209-221, 05.
  5. M Kesriyeli & D R Osborn & M Sensier, 2004. "Nonlinearity and Structural Change in Interest Rate Reaction Functions for the US, UK and Germany," Centre for Growth and Business Cycle Research Discussion Paper Series 44, Economics, The Univeristy of Manchester.
  6. David Gruen & Michael Plumb & Andrew Stone, 2005. "How Should Monetary Policy Respond to Asset-Price Bubbles?," International Journal of Central Banking, International Journal of Central Banking, vol. 1(3), December.
  7. Granger, Clive W J, 1993. "Strategies for Modelling Nonlinear Time-Series Relationships," The Economic Record, The Economic Society of Australia, vol. 69(206), pages 233-38, September.
  8. Tim Robinson & Andrew Stone, 2005. "Monetary Policy, Asset-Price Bubbles and the Zero Lower Bound," NBER Working Papers 11105, National Bureau of Economic Research, Inc.
  9. van Dijk, D.J.C. & Terasvirta, T. & Franses, Ph.H.B.F., 2000. "Smooth transition autoregressive models - A survey of recent developments," Econometric Institute Research Papers EI 2000-23/A, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
  10. James B. Bullard & Eric Schaling, 2002. "Why the Fed should ignore the stock market," Review, Federal Reserve Bank of St. Louis, issue Mar., pages 35-42.
  11. Sharon Kozicki, 1999. "How useful are Taylor rules for monetary policy?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-33.
  12. Stephen G. Cecchetti & Hans Genberg & Sushil Wadhwani, 2002. "Asset Prices in a Flexible Inflation Targeting Framework," NBER Working Papers 8970, National Bureau of Economic Research, Inc.
  13. Jagjit S. Chadha & Lucio Sarno & Giorgio Valente, 2004. "Monetary Policy Rules, Asset Prices, and Exchange Rates," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 529-552, November.
  14. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  15. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  16. Welz, Peter & Österholm, Pär, 2005. "Interest Rate Smoothing versus Serially Correlated Errors in Taylor Rules: Testing the Tests," Working Paper Series 2005:14, Uppsala University, Department of Economics.
  17. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  18. Robert B. Davies, 2002. "Hypothesis testing when a nuisance parameter is present only under the alternative: Linear model case," Biometrika, Biometrika Trust, vol. 89(2), pages 484-489, June.
  19. Roberto Rigobon & Brian Sack, 2001. "Measuring the reaction of monetary policy to the stock market," Finance and Economics Discussion Series 2001-14, Board of Governors of the Federal Reserve System (U.S.).
  20. John Duffy and Jim Engle-Warnick, 2001. "Multiple Regimes in U.S. Monetary Policy? A Nonparametric Approach," Computing in Economics and Finance 2001 151, Society for Computational Economics.
  21. Owyang, Michael T. & Ramey, Garey, 2001. "Regime Switching and Monetary Policy Measurement," University of California at San Diego, Economics Working Paper Series qt24q32688, Department of Economics, UC San Diego.
  22. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
  23. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  24. Robert J. Tetlow & Peter von zur Muehlen, 2002. "Monetary Policy, Asset Prices, and Misspecification: the robust approach to bubbles with model uncertainty," Computing in Economics and Finance 2002 335, Society for Computational Economics.
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Citations

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Cited by:
  1. Nikolay Markov & Thomas Nitschka, 2013. "Estimating Taylor Rules for Switzerland: Evidence from 2000 to 2012," Working Papers 2013-08, Swiss National Bank.
  2. Nikolay Markov & Carlos de Porres, 2011. "Is the Taylor Rule Nonlinear? Empirical Evidence from a Semi-Parametric Modeling Approach," Research Papers by the Department of Economics, University of Geneva 11052, Département des Sciences Économiques, Université de Genève.
  3. Nikolay Markov, 2010. "A Regime Switching Model for the European Central Bank," Research Papers by the Department of Economics, University of Geneva 10091, Département des Sciences Économiques, Université de Genève.

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